Greece's bonds also hit record levels after Wednesday's violent riots piled fresh pressure on an Athens government already on the edge. There was also concern that Europe lacks the firepower to bring the ongoing debt crisis under control, with a member of the European Central Bank (ECB) warning that the existing rescue package needs to be doubled to €1.5 trillion (£1.3tn).

In London, the FTSE 100 had shed almost 100 points by 1pm to 5645.8, a drop of 1.7%. Just three shares were higher, as the blue-chip index hit its lowest level since 17 March.

European markets also suffered losses. France's CAC dropped by 1.5%, led by French banks which have large exposure to Greek debt, while the German DAX was 0.7% lower. Earlier, the panic in Greece touched Asia, with Japan's Nikkei dropping by 1.7% to 9411.28 in a nervy session.

The euro also suffered, hitting a three-week low against the dollar, as traders warned that a Greek default would have catastrophic consequences for the global markets.

Cameron Peacock of IG Markets said: "With Greek sovereign debt squarely back on the agenda, risk appetite among traders is very much off and equities are coming under sustained pressure as a result.

"A new government is set to be formed in Athens today against a backdrop of civil unrest and the big concern is that politics gets in the way of the second tranche of the bailout, in turn forcing a debt restructuring in the eurozone," Peacock added.

George Papandreou, the Greek prime minister, suffered another blow on Thursday when two members of his government resigned, including former deputy finance minister George Floridis.

Floridis criticised both Papandreou and Greece's opposition leaders, accusing them of putting party politics ahead of the needs of the nation.

Papandreou is expected to announce a wide-ranging cabinet reshuffle later on Thursday, having failed to unite Greece's political parties behind his hugely unpopular austerity programme.

"Markets roiled"

Bond traders continued to view Greek debt as hugely risky. The yield, or effective interest rate, on Greek two-year bonds hit 29.639%, a new record. The cost of insuring Greek debt against collapse spiked, with the five-year credit default swap leaping 174 basis points to a record high of 1,900, according to Markit. That means it would cost €1.9m per year to insure €10m of Greek debt.

"The impasse within the institutions of the EU, as well as the political and social upheaval within Greece, has roiled the markets," said Gavan Nolan, director of credit research at Markit.

European leaders have been debating their next move in the Greek crisis for several weeks, after it became clear that the country needs a second bailout. However, it is unclear how a plan can be drawn up that will save Greece from default.

One option is to restructure of some of its €330bn debt, with lenders agreeing to defer repayments. Credit rating agencies, though, have warned that such a plan would be treated as a default.

Gary Jenkins, head of fixed income research at Evolution Securities, did not believe that the debt "reprofiling" was feasible. "I still fail to see why an investor would want to agree to extend maturities rather than get paid back in full and on time," said Jenkins. "If the choice is extend or default then it could be argued that it is not a voluntary decision and certainly the rating agencies will regard it as a default."

Earlier, ECB governing council member Nout Wellink predicted that the European bailout fund should be doubled to €1.5tn, to stave off the risk of a new Greek bailout triggering renewed crisis in Ireland and Portugal.

"If you take these risks, you need to build a safety net," Wellink told Dutch newspaper Het Financieele Dagblad. "If ratings agencies see a rollover [of Greek debt] as a partial default, contagion to other peripheral eurozone countries will occur."